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What Happens When Phantom Profits Vanish?

As the U.S. dollar strengthens against other currencies, the phantom corporate profits generated by a devaluing dollar will vanish.

One of the dirty little secrets of the stock market rally is that the rising corporate profits that powered it are largely phantom profits. Why are they phantom? Because they are artifacts of currency devaluation, not an increase in efficiency or production of goods and services.

Though few domestic observers make mention of it, the large, global U.S.-based corporations are now dependent on non-U.S. sales for about 40% of their revenues (50% and up for many companies) and virtually all their profit growth. Overseas sales are made in the local currency: the euro, yen, renminbi, Australian dollar, Canadian dollar and so on, and the profits are stated in U.S. dollars on corporate profit and loss statements.

In 2002, 1 euro of profit earned by a U.S. global corporation equaled $1 in profit when converted to U.S. dollars. That same 1 euro profit swelled to $1.60 in 2008 as the U.S. dollar depreciated against the euro. That $ .60 of profit was phantom, an artifact of the depreciating dollar; it did not result from a higher production of goods and services or greater efficiencies.

This is why profits earned in non-U.S. markets have risen so dramatically even as domestically earned profits have stagnated. The U.S. dollar has declined dramatically against the currencies of our major trading partners, boosting phantom profits across the board when the non-U.S. profits are converted to U.S. dollars on corporate profit and loss statements.

The Federal Reserve has actively pursued a policy of devaluing the dollar, supposedly in the hopes of expanding exports as it became cheaper to buy goods and services denominated in U.S. dollars. While exports have nudged up as the dollar lost value, the truly significant result of this policy was boosting foreign exchange-generated profits of global U.S. corporations.

Now that the Federal Reserve has lowered interest rates to zero, trying to depreciate the dollar further is like pushing on a string. Short of direct foreign exchange (forex) intervention–buying other currencies in bulk and selling dollars to flood the market with USD–there is little the Fed can do to manipulate the $2 trillion-a-day foreign exchange markets.

The strengthening dollar is putting these vast phantom profits at risk. Were the U.S. dollar to return to its 2002 relative value in other currencies, virtually all the phantom (forex-generated) corporate profits that have justified the stock market rally will vanish.

Though very few consider it possible, much less likely, the U.S. dollar could actually rise significantly as other currencies price in the currently understated risk to their economies. Were that to happen, U.S. corporate profits earned in other currencies would actually decline, even if revenues remained constant.

If the global economy is indeed sliding into recession, then maintaining revenues will be a challenge. More likely, sales will drop and so will profits as the dollar reverses and overseas profits plummet when converted to dollars.

In other words, if the dollar continues strengthening against other currencies, say good-bye to rising corporate profits–and the stock market rally based on ever-expanding corporate profits. Is it any wonder that the Powers That Be look upon a strengthening dollar (recall a rising dollar increases the purchasing power of all who hold it, i.e. U.S. residents and those holding dollar-denominated bonds) with fear and loathing? Alas, the Federal Reserve is not all-powerful in forex markets, despite its gargantuan hubris and absurdly inflated reputation.

About The Author

Charles Hugh Smith writes the Of Two Minds blog (www.oftwominds.com/blog.html) which covers an eclectic range of timely topics: finance, housing, Asia, energy, longterm trends, social issues, health/diet/fitness and sustainability. From its humble beginnings in May 2005, Of Two Minds now attracts some 200,000 visits a month. Charles also contributes to AOL’s Daily Finance site (www.dailyfinance.com) and has written eight books, most recently “Survival+: Structuring Prosperity for Yourself and the Nation” (2009) which is available in a free version on his blog.